Organizational Design, Competition, and Financial Exchanges

• Date: 01 January 2020
• DOI: http://doi.org/10.1111/sjoe.12325
• Published date: 01 January 2020
• Author: Steffen Juranek,Uwe Walz

Scand. J. of Economics 122(1), 132–163, 2020

DOI: 10.1111/sjoe.12325

Organizational Design, Competition, and

Financial Exchanges*

Steffen Juranek

Norwegian School of Economics (NHH), NO-5045 Bergen, Norway

steffen.juranek@nhh.no

Uwe Walz†

Goethe University Frankfurt, DE-60323 Frankfurt, Germany

uwe.walz@wiwi.uni-frankfurt.de

Abstract

We investigate the incentives for vertical and horizontal integration in the financial securities

service industry. In a model with two exchangesand two central securities depositories (CSDs),

wefind that decentralized decisions might lead to privately and socially inferior industry equilibria

with vertical integration of both CSDs with their respective exchanges. Allowingfor horizontal

integration of CSDs avoids privatelyinferior industr y equilibria. However, weobserve too little

horizontal integration from the social perspective. We link our results to recent regulatory and

institutional developments such as the emergence of multilateral trading facilities, over-the-

counter regulation, and financial harmonization.

Keywords: Competition; horizontal integration; settlement; trading; vertical integration

JEL classification:G15; G23; L13; L22

I. Introduction

Financial exchanges play a key role in the financial system. In recent

decades, changes in technology and regulation, as well as in market

structure resulting from a large number of mergers, have shown

the dynamics of the industry. Unfortunately, the interrelation between

competition and market structure, and therein the impact of technological

developments and regulation, is not well understood (Cantillon and Yin,

2011). We aim to fill this gap by analyzing vertical mergers of exchanges

and central securities depositories (CSDs), as well as horizontal mergers

of CSDs. Our analysis focuses on cost changes induced by technological

compatibility associated with the integration decision. By taking into

*We are grateful to Kai-Oliver Maurer and Martin Reck (Deutsche B¨orse) and their teams for

helpful conversations on the structure of the industry. The paper benefited significantly from

comments and suggestions fromseminar participants atFrankfurt, Vienna, T ¨ubingen, and several

conferences. Weacknowledge in particular the comments of two anonymous referees.

†Also affiliated with the Center for Financial Studies, Frankfurt, Germany.

C

The editors of The Scandinavian Journal of Economics 2018.

S. Juranek and U. Walz 133

account the specific characteristics of the financial securities service

industry, such as the existence of over-the-counter (OTC) trading and the

natural monopoly position of CSDs, we derive the organizational structure

that emerges in equilibrium. We examine under what circumstances vertical

integration and the associated changes of the cost structure are profitable,

and when horizontal integration of CSDs outcompetes vertical integration.

Finally, we evaluate the resulting equilibrium from a private and social

perspective. Based on these insights, we analyze the role of recent industry

developments.

Understanding the interaction between competition and market structure

in the financial securities service industry, as well as the influence of

technological change on this interaction, is decisive for market participants

and policy makers. Examples of both horizontal integration of CSDs and

vertical integration have been observed in the recent past. Today, Euroclear

acts as the CSD for a handful of countries, while the merger of Deutsche

B¨orse and Clearstream in Germany is a prime example of a vertical merger.

The organizational choice turned out to be important for the subsequent

consolidation process. For example, the vertically integrated structure of

Deutsche B¨orse has proved an obstacle for various merger plans of Deutsche

B¨orse, including the recent Deutsche B¨orse/London Stock Exchange merger

proposal in 2017.1

A securities transaction requires three functions: trading, clearing, and

settlement. Whereas trading, and usually also clearing, is performed by the

exchange, the settlement of the transaction is performed by CSDs. To date,

we observe very different industry structures across different continents and

markets. In Europe, we find roughly 20 national exchanges and a similar

number of CSDs (Federation of European Securities Exchanges, 2012).

In the US market, there are a dozen exchanges and two CSDs. Despite

the larger number of exchanges and CSDs in Europe and the efforts of

the European Union to increase competition in investment services – for

example, as part of the Markets in Financial Instruments Directive (MiFID)

– we observe a higher concentration of trading and settlement of a single

stock in Europe, typically related to the national borders. Furthermore,

the organizational form differs significantly among European countries and

markets. For example, we see vertical integration of the main exchange

and the national CSD (also referred to as a vertical silo) in Germany, Italy,

and Norway, and vertical separation in other markets, such as the United

Kingdom, France, and Sweden.

We use a stylized model with two pairs of exchanges and CSDs to

analyze vertical integration, as well as the horizontal integration decision

1See the article “Battle of the bourses” inThe Economist on25 May 2006 (https://www.economist.

com/special-report/2006/05/25/battle-of- the-bourses).

C

The editors of The Scandinavian Journal of Economics 2018.

134 Organizational design, competition, and financial exchanges

OTC market

Exchange A Exchange B

CSD A CSD B

OTC market

Exchange A Exchange B

CSD A CSDB

Vertical integration Vertical integration Horizontal integration

Fig. 1. Supply side: potential industry structures

from the viewpoint of the CSDs. Whereas the CSDs are monopolists, the

exchanges compete with each other and the OTC market. We allow for

a substitution effect between exchanges and the OTC market by letting

a subsegment of traders choose between trading on the exchanges or on

the OTC market. Figure 1 illustrates this set-up and the potential industry

structures that we cover in our analysis. The industry can be completely

separated, or one or both pairs of an exchange and a CSD can integrate

vertically (i.e., partial or full vertical integration occurs), or the CSDs

can integrate horizontally. Thereby, we neglect combinations of horizontal

and vertical integration that are exposed to antitrust considerations (see

the European Commission’s rejection of the latest Deutsche B¨orse/London

Stock Exchange merger plan; European Commission, 2017). Hence, our

model is closely aligned with the European case in which an organization

emerged from previously national systems.

We model vertical integration such that it facilitates the operative

and technical relations along the value chain of the vertically integrated

silo. The specifically designed link between the CSD and the associated

exchange makes trades routed through it less costly. However, it imposes

additional costs on external transactions (i.e., trades originated on other

trading platforms or the OTC market). Hence, our approach builds on the

advantages of vertical integration stressed in the literature on the theory

of the firm, namely the reduction of transaction costs (Williamson, 1985)

by allowing for specific investments, which have a higher value inside an

organization than outside it (Grossman and Hart, 1986). In order to avoid

mixing the results with the effects of joint fee-setting, fees remain to be

determined in a decentralized manner after a merger.

We find that vertical integration is more likely if the domestic exchange

has a strong relative advantage over the competing exchange and the

OTC market, if the cost changes are pronounced, and if the general gains

from trade from securities trading, per se, are high. A strong relative

advantage of the domestic exchange implies that trading is concentrated

on the domestic exchange, leading to relatively high cost savings for

C

The editors of The Scandinavian Journal of Economics 2018.